FM3 Notes

FACULTY OF ACCOUNTING & INFORMATICS
DEPARTMENT OF MANAGEMENT ACCOUNTING
PROGRAMME TITLE: Diploma in Management Sciences

(Business Administration)
PROGRAMME CODE: DIMBS1
SUBJECT TITLE: FINANCIAL MANAGEMENT III
SUBJECT CODES: FNMG301
SAQA CREDITS: 12 credits
STUDY GUIDE 2024
Revised by: Mr Thabiso Sthembiso Msomi
04/01/2024
1. GENERAL INFORMATION
Names of Lecturer : MR THABISO STHEMBISO MSOMI

Office : DC1204H
Campus location : Ritson Campus
Telephone : (031) 373 5740
E-Mail : thabisom4@dut.ac.za
Consultation times with lecturer: will be discussed in class
Departmental Secretary : Bongekile Giqwa

Room number : DC1204C
Contact details : 031 373 5644
Fax No : 031 373 5226
E-Mail : bongekilen@dut.ac.za
Departmental HEAD : Dr Zwelihle Wiseman Nzuza
Room number : DC1204F

Contact details : 031 373 5351
Fax No : 031 373 5226
E-Mail : zwelihlen@dut.ac.za
Lectures : 4 periods per week

Lecture Venues : As per timetable
Consultation Times : See lecturers’ consultation timetables
Duration of Course : 1 semester
Page 2 of 72
Content Page
Chapter 1: Corporate Governance, Ethics and Agency Issues 03
Chapter 2: Short Term Financial Planning and Current Asset 08
Management
Chapter 3: Long Term Financial Planning and Growth 17
Chapter 4: The Cost of Capital/ Business valuation 23
Chapter 5: Dividends and Dividend Policy 39
Chapter 6: Capital Budgeting and Project Evaluation 45
Chapter 7: Risk and Return 66
Time value of money tables 71
Assessment
Two mandatory tests plus (any modifications will be communicated):
Test 1; Test 2; Assignment
The continuous assessment is calculated as the better of the two marks (DP Mark)
divided by two, multiplied by 40%. The examination mark contributes 60% to the final
grade. The overall final mark is determined by combining the continuous assessment
(40%) and the examination mark (60%). Note: There will be no opportunity for makeup
tests.
The following important rules apply to the aegrotat test: -

➢ The aegrotat test will cover the entire semester’s work.
➢ Not all students will be permitted to write the aegrotat test, it is strictly for those
students who have missed the control tests and have a valid medical reason
for doing so.
➢ Students will be required to submit a medical certificate to their lecturer, within 5
working days of missing a control test, before being granted permission to
write the aegrotat test.
➢ Only one aegrotat test will be set for the entire semester.
➢ NO ADDITIONAL TESTS WILL BE SET UNDER ANY CIRCUMSTANCES.
ASSESSMENT DATES: (provisional dates)
Test 1 : TBC
Test 2 : TBC
Assignment : TBC
AEGROTAT Test : TBC
NB: These are provisional dates subject to change based on the accounting
cluster test week allocation.
Page 3 of 72
TEMPLATE: MODULE DESCRIPTOR
Faculty MANAGEMENT SCIENCES Department

Contact details for Verna Yearwood Version
department/ programme co- number 1
ordinator
Site/s of delivery Durban and Pietermaritzburg Date November 2012
1 Module title FINANCIAL MANAGEMENT 3 2

3 Gen Ed Theme N/A 4 Gen Ed Code W Q KZ
(name where (where R N
applicable) applicable)
5 HEQSF level 6 6 HEQSF Credits 16

7 CESM 0406 8 Annual/semest Semester
er
9 Year in which 3 1 Compulsory or COMPULSO
offered (Yr 1, 2, 3 0 elective RY
etc)
11 Total notional 160 1 Contact hours 80
hours 2
13 Pre-requisite YES 1 Co-requisite
module/s 4 module/s N/A
Title FINANCIAL MANAGEMENT 2 Title
Code Code
15 Programme/s name/s Diploma in Management Sciences
16 Purpose of this module in Provide the fundamental financial management principles
relation to the programme/s building on the basic principles to enhance decision-making at
management levels.
17 Learning outcomes 1. Demonstrate understanding of the financial planning
process
2. Determine the valuation of bonds and shares
3. Apply various capital budgeting techniques to assist in
capital investment decisions
4. Utilise Break-even concepts and analysis in its various
forms to identify critical levels of sales
5. Interrogate the effect of financial leverage and capital
structure on the firm’s value.
6. Explain the concepts underlying dividend policy
7. Discuss the importance of short-term financial planning.
8. Discuss the importance of the management of investment
in current assets.
9. Understand cash and liquidity management in a firm.
10. Explain credit policy and the management of credit in an
organisation.
11. Interrogate the meaning and fundamental of risk and return
12. Discuss the risk and return characteristics of a portfolio in
terms of correlation, and diversification, and the impact of
assets on a portfolio.
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13. Explain the Capital Asset Pricing Model and its relationship
to the Security Market Line
18 Graduate attributes developed Basic Proficiency and Competency in Financial
and/or assessed in this Management
module Innovation by means of students using computers
Students will engage critical with both national and
international finance.
Broad understanding of Financial management in the
workplace
19 Module content 1. Long Term Financial Planning and Growth
2. Valuation of Bonds and Shares
3. Capital Budgeting and Project Evaluation
4. Cost of Capital, Capital Structure and Dividend Policy
5. Risk and Return
6. Short term Financial planning and Management
7. Corporate Governance
20 Teaching and learning
Learning activity % learning
time
Contact time 50
Reading 20
Tutorial 10
Library 10
Assessments 10
21 Assessment and moderation Does assessment include a final examination?
YES. 40 % YM, 60 % EXAM YES
Year mark: 40 %
Exam mark: 60 %
As this is an exit level subject, assessments will be externally
moderated.
22 Feedback to students on Within 10 working days
assessment
23 Resources required to offer Lecture Venue, Data Projector, Newspapers, Magazines
this module
24 Student numbers No limits for Full time
Minimum of 15 students for part time.
25 Quality assurance “The university’s quality assurance policies and procedures will
provide the QA for this module. Inter alia, subject and lecturer
evaluation questionnaires will be administered once per
module. A regular review of the module assessments will allow
reflection on the level of achievement of module outcomes.
This reflection will allow modification to teaching and learning
and assessments where necessary. Feedback will be provided
to students via staff/student meetings.”
26 Motivation for additional
credits
Tracking changes to the module descriptor [to be completed by CQPA]
Page 5 of 72
Version Section number and Approved Date of Relevant
details of change by approval departments
informed
2
3
4
CHAPTER 1: Corporate Governance, Ethics and

Agency Issues
EXPECTED OUTCOMES:
• Define corporate governance
• Sources of Corporate Governance
• Approaches to Corporate Governance
• Rolls in the company
• Agency issues
1. What is corporate governance?
A system through which powers are exercised and shared by different stakeholders and
groups to ensure the achievement of the entity’s goals.
2. Sources of Corporate Governance
There are three 3 sources for Corporate Governance:

i. Law – common and legislation
ii. Best Practice Codes
iii. Books
3. Approaches to Corporate Governance
There are 4 approaches in the practice of corporate governance:
a. The Shareholder Value Approach
Expresses the view that a Board should govern entities in the best interests of all
shareholders. In practice the shareholder value approach to corporate governance is
generally accepted.
b. Stakeholder Approach (practiced in Zimbabwe)
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Expresses the view that directors should run entities in the interests of all stakeholders of
the company.
c. The Integrated Approach
This approach was advocated by all the three King Reports especially in the area of
reporting and disclosures. It takes the view that companies have a wide range of
stakeholders whose views should be considered and that corporate governance should
encourage participation by all the stakeholders.
4. Rolls in the company
The role of the entity’s CEO
• In line with best practice, the entity’s Board should appoint and terminate the
CEO’s contract without reference to the shareholders although in most companies,
shareholders demand that they be informed.
• The entity’s CEO should operate in terms of the authority delegated by the entity’s
Board.
• The entity’s CEO develops strategies, policies, budgets and business plans for
consideration and approval by the entity’s Board.
The company Secretary and Corporate Governance
Not all codes on corporate governance specify the role for the Company Secretary.
But King II identifies the Company Secretary as having “… a pivotal role to play”.
A company secretary bears the following tasks and responsibilities, namely:
• Assists the Chairman of the Board with preparing for, conducting and reporting the
outcome of board meeting and general meetings of the company.
• Attends those meetings and takes minutes.
• Is involved in the counting of proxy votes from shareholders for a General Meeting
although the detailed counting is likely to be done by the company auditors.
• Notifies shareholders of changes in their shareholding – not only shareholders but

also Board members.
• Advises directors of the closed periods during which they can deal in shares of the
companies in which they provide leadership.
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• Assists the Chairpersons of Committees of Board, i.e. Audit, Remuneration &
Nominations Committees and attends committee meetings.
• Arranges insurance cover for board members.
• Advises the Board Chairman and Board members on legal issues and issues of
procedure.
The Company Lawyer and Corporate Governance
The in-house company lawyer is an alternative to the company secretary as a source of

knowledge on corporate governance.
He or she bears the following responsibilities:
• Offers advice to the Board on legal risks, i.e. risks to the company flowing from the
consequences of breaching the law or any other regulations.
• Offers advice on current legal developments and new legislation and codes on
good corporate governance codes, standards and guidelines.
The Shareholders
Shareholders are the owners of the company and have certain rights namely:
• The right to attend and vote at General and Special Meetings of the company.
• The right to remove a director from office – a group of shareholders proposing to

remove a director from office have the right to call a General meeting of the
company.
• However, there are some instances where the majority voting power have been
used to oppress minority rights.
The Role of the entity’s Stakeholders
The stakeholders including owners of the entity should define the entity’s objectives.
These guide the directors in conducting the affairs of the company
• Appointing the first directors to conduct the affairs of the company
• Attend stakeholder meetings.
Other Stakeholders – employees, customers, lenders & other creditors, investment

institutions
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• All the above stakeholders have one common interest with regard to the business
operation of the company, that is, its sustainability. “The shareholder who is happy
with the capital growth of his shares or his dividends wants to know that the
business is a sustainable one.
• The employee, who has employment and is able to support his family, wants to
know that his employment will continue.
• The suppliers obviously want the company which they supply to continue to be a
successful one.
• Customers want companies that produce good products to continue to do so.
• The local community in which the company carries on its business, offering men
and women in that community the opportunity to improve themselves, also wants
the company to be a sustainable one.
• Even the regulator who is content that the company is using its best endeavors to
comply not only with the letter but the spirit of the regulations, wants the company
to be sustainable.
The General Public – corporate social responsibility
Best managed companies are those that are aware of their corporate social
responsibilities, i.e. responsibilities towards all stakeholders and society as a whole.
Corporate social responsibility refers to business decision making linked to ethical values,
compliance with legal requirements and respect for people, communities and the
environment
5. Agency issues
What is the role of agency theory in corporate governance?
Agency theory is used to understand the relationships between agents and principals.
The agent represents the principal in a particular business transaction and is expected
to represent the best interests of the principal without regard for self-interest.
The different interests of principals and agents may become a source of conflict, as some
agents may not perfectly act in the principal's best interests. The resulting
miscommunication and disagreement may result in various problems and discord within
companies. Incompatible desires may drive a wedge between each stakeholder and
cause inefficiencies and financial losses. This leads to the principal-agent problem.
The principal-agent problem occurs when the interests of a principal and agent conflict.
Companies should seek to minimize these situations through solid corporate policy.
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These conflicts present normally ethical individuals with opportunities for moral hazard.
Incentives may be used to redirect the behavior of the agent to realign these interests
with the principal's concerns.
Corporate governance can be used to change the rules under which the agent operates
and restore the principal's interests. The principal, by employing the agent to represent
the principal's interests, must overcome a lack of information about the agent's
performance of the task. Agents must have incentives encouraging them to act in unison
with the principal's interests. Agency theory may be used to design these incentives
appropriately by considering what interests motivate the agent to act. Incentives
encouraging the wrong behavior must be removed, and rules discouraging moral hazard
must be in place. Understanding the mechanisms that create problems helps businesses
develop better corporate policy.
To determine whether or not an agent acts in his or her principal’s best interest, the
standard of “Agency Loss” has emerged as a commonly-used metric. Strictly defined,
agency loss is the difference between the optimal results for the principal and the
consequences of the agent’s behavior. For example, when an agent routinely performs
with the principal’s best interest in mind, agency loss is zero. But the further an agent’s
actions diverge from the principal’s best interests, the greater the agency loss becomes.
Agency loss drops when the following situations occur:
• The agent and principal both hold similar interests of achieving the identical
income.
• The principal is mindful of the agent’s activities, so the principal has a keen
knowledge of the level of service he is receiving.
If neither of these events occurs, agency loss is likely to climb. Therefore, the chief
challenge involves persuading agents to prioritize their principal’s best interest while
placing their self-interest second. If done correctly, the agent will nurture their principal’s
wealth, while incidentally enriching their bottom lines.
Source: https://www.investopedia.com/ask/answers/031815/what-role-agency-theory-
corporate-governance.asp
Class exercise 1
1.1 Define what is ‘corporate governance’

1.2 List sources of Corporate Governance
1.3 Discuss approaches to Corporate Governance
1.4 List the roles of each stakeholder in corporate governance
1.5 Discuss agency issues in the company
Solution
Solution for this exercise will be provided in class by the lecturer
Page 10 of 72
CHAPTER 2: SHORT TERM FINANCIAL
PLANNING AND CURRENT ASSET
MANAGEMENT
1. EXPECTED OUTCOMES:
• Cash management
• Credit management
• Inventory management
• Current asset management
2. CASH MANAGEMENT
Reasons for holding cash
- Speculative motive
The need to hold cash in order to take advantage of opportunities that may arise.
- Precautionary motive
The need for a safety supply of cash to act as a financial reserve.
- Transaction motive
The need to have cash on hand to pay accounts.
FLOAT, CASH COLLECTION AND CONCENTRATION

Float Is the difference between “book” cash (i.e. that in the firm’s
accounting records) and “bank” cash (i.e. the available balance
reflected in the bank account). Float represents the net effect of
cheques in the process of clearing.
Disbursement float Is generated by the cheques issued by the firm which have
been entered in the firm’s cash book but not yet presented at
the bank for payment. Disbursement float therefore increases
cash available.
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Collection float Is generated by cheques received by the firm and entered in the
cash book but not yet cleared through the bank account.
Collection float therefore reduces cash available.
Net float Is the sum of disbursement and collection float. To a large
extent float is being eliminated or greatly reduced by electronic
data interchange (EDI), also called electronic funds transfer
(EFT).
Cash Is the practice of and procedures for moving cash from multiple
concentration banks into the firm’s main accounts.
Cash bulking Is the practice of adding together the balances in various bank
accounts controlled by a firm so that it can earn a higher rate of
interest.
Costs of Holding Cash
Cash held in excess of a necessary minimum incurs an opportunity cost which is the
interest that could have been earned in the next most liquid use.
3. CREDIT MANAGEMENT
Components of Credit Policy

Terms of sale:
• The conditions under which a firm sells its goods for cash or credit.
• Deals with whether the firm will sell for cash or on credit.
• If credit is to be granted, the credit period and any cash or settlement discount that
may be offered.
Credit analysis - The process of determining the probability that customers will or
will not pay. Deciding who the firm should grant credit to.
Collection policy - Procedures followed by a firm in collecting accounts receivable.

Once credit has been granted, the firm must establish a
procedure to ensure that cash is collected when it becomes due.
Credit Period
• In SA, terms are normally calculated from statement date (month-end or some other
fixed date each month), but sometimes from invoice date (this is common in USA).
• Terms of 30 days from statement date means that effectively the customer receives
on average 45 days credit from date of purchase.
• Length of the credit period varies from industry to industry.
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• A major influence on the credit period is the buyer’s inventory period and operating
cycle. All other things being equal, the shorter these are, the shorter the credit period
need be.
• Other factors influencing credit period:
o Perishability and collateral value

o Consumer demand
o Cost, profitability and standardization.
o Credit risk
o Size of the account
o Competition
o Customer type
Terms of Sale
• Indicate credit period and settlement discount (if any0 being offered to customers.
• Terms of 2.5 / 30, net 60 means customer receives 2.5% discount for payment within
30 days, or must pay the full amount within 60 days.
• Example: if the amount owing is R1000, terms of 2.5 / 30, net 60 means customer
must pay R1000 x (1 - .025) = R975 within 30 days or R1000 in 60 days.
Cash (Settlement) Discounts

• Reason for offering discounts is to speed up collections and ultimately reduce amount
of credit being offered.
• When the discount is offered, the credit is basically free for the discount period, and
the buyer effectively only pays for credit when the discount expires.
• The implicit interest rate for not taking discount is normally very high.
4. INVENTORY MANAGEMENT
Inventories often make up a significant portion of a firm’s assets and affect its operating
cycle, therefore it is important to set an effective inventory policy and manage inventories
correctly. Inventory management is an important specialty in its own right, and
purchasing, production and marketing management as well as financial management
have a role to play in inventory management.
Inventory Classification
Raw materials These are materials on hand for use in production.
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Work in progress (WIP) WIP is an unfinished product in the process of
manufacture.
Finished goods These are the products ready to dispatch or sell.
Consumable stores These are items purchased for use in the business which
are not used directly in the manufacture of finished
products.
Inventory Costs
Carrying costs Costs of keeping inventory on hand; e.g. storage, insurance,

losses due to obsolescence or theft, opportunity cost of
capital.
Shortage costs Costs resulting from not having enough inventories on hand;
include profit on lost sales, restocking costs, loss of goodwill
through being unable to supply.
A trade-off exists because carrying costs increase when inventory increases, and
shortage costs increase when inventory decreases. The basic goal of inventory
management is to minimize the sum of carrying and shortage costs.
Inventory Management Techniques
5. ABC approach
ABC is a simple approach which involves separating inventory items according to value,
and monitoring the high value items more closely.
Economic Order Quantity (EOQ) model
EOQ is the order level that will minimize the total cost of carrying and reordering inventory.
In the EOQ model it is assumed that inventory is used or sold at a steady rate, and when
used up is re-ordered and stock is replenished. EOQ is a best-known approach to
establishing an optimal level of inventory.
The EOQ formula
EOQ = 2DO
C/H
D = Annual quantity demand
O = Ordering cost per unit
C/H= Inventory carrying costs also called inventory holding costs
Extensions to EOQ model
Safety stocks Safety stock is the minimum stock level a firm wishes to hold to
avoid running out. When stock reaches this level it is re-ordered.
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Re-order level Re-order level a time period elapses between ordering and
delivery of stock (lead time). Re-order level takes this into
account: it is the point at which stock is re-ordered so that during
the delivery period usage will bring the stock level down to safety
stock.
Just In Time (JIT) JIT is a philosophy which requires that inventories be minimized
Inventory by ordering only enough for usage to be delivered when it is
Management required to be used.
First In First Out FIFO is a system in which the first items entered are the first to
(FIFO) be removed.
Last In First Out LIFO is a system in which the last items entered are the first to
(LIFO) be removed.
Illustrative example 1: Cash management and EOQ
PART A
a) Give 3 reasons for holding cash

b) What costs result from a firm holding cash?
c) What causes disbursement and collection float?
d) List 4 types of short-term borrowing that a firm may use.
e) What makes LIFO different from FIFO?
PART B
The following information relates to purchases of Christ Co’s only material:
Daily usage 300 units

Ordering cost R1000
Carrying cost per kg R1000
Safety stock 1000kg
Average lead time 2 days
The company works 365 days per year.
Required:
a. Calculate the economic order quantity.
b. Calculate the number of orders to be placed per year.
c. Calculate the annual ordering cost?
Solution
PART A
a) Three reasons for holding cash:

1. Speculative motive
2. Precautionary motive
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3. Transaction motive
b) Opportunity costs
c) Causes of disbursement and collection float
1. Disbursement is generated by the cheques issued by the firm which have been
entered in the firm’s cash book but not yet presented at the bank for payment.
2. Collection float is generated by cheques received by the firm and entered in the
cash book but not yet cleared through the bank account.
d) Types of short-term borrowing
1. Bridge Loan
2. Trade credit
3. Bank overdraft
4. Business credit card
e) FIFO allows first in items to be issued first whereas LIFO allows last in items to be
issued first.
Solution
PART B
√2DO √2(109500)(R1000) √219000 000

1. EOQ = = = = √219000 = 468 U
H R1000 R1000
D 109 500
2. Annual orders = EOQ = = 234 orders
468
3. Annual ordering cost = Annual orders x ordering costs
= 234 x R1000 = R234 000
Illustrative example 2: EOQ

Gazu Ltd manufactures fiberglass surfboards. One of the raw materials is a special
resin used to bind the fiberglass in the moulding phase of production. The production
manager, Sizwe, uses an economic order quantity decision-making model to
determine the size and frequency of resin orders.
Resin is purchased in 50-liter drums, and 9 800 drums are used each year. Each
drum costs R350. The controller estimates that the cost of placing and receiving a
typical resin order is R158. The controller’s estimate of the annual cost of carrying
resin in inventory is R4.20 per drum plus R1 insurance cost. Further information that
relates to fiberglass surfboards is as follows:
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Lead time 10 to 15 working days
Average usage 25 drums per day
Minimum usage 10 drums per day
Maximum usage 15 drums per day
Required
If Sizwe orders 700 liters of resin in each order placed during the year. Calculate the
following:
a. Indicate economic order quantity from above
b. Annual cost of ordering
c. Annual carrying cost
Solution
1. 700 liters given
2. Annual cost of ordering
Step 1: calculate total number of orders to be placed pa
= Annual demand/EOQ
= 9800/700
= 14 orders
Step 2: calculate annual cost of ordering
= Annual orders x ordering cost
=14 orders x R158
= R2 212
3. Annual carrying cost
= Average quantity in inventory X annual carrying cost per drum
= 350 x R5.2 (R4.20 + R1)
= R1 820 √
Illustrative example 2: Cash flow
Abridged financial statements for STOLBA-T Ltd are as follows:
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Statement of Comprehensive Income for the year ended 31 December 2022
R
Sales (70% is cash) 1 756 000 1 229 200
Cost of Sales (60%) (943 000) (565 800)
Gross profit 813 000 663 400
Depreciation (65 000) (65 000)
Profit before Interest and Tax 748 000 598 400
Interest (41 000) (41 000)
Profit before Tax 707 000
Tax (212 100)
Net profit after tax 494 900
Dividend paid 135 000
Retained profit 359 900
Statement of Financial Position as at 31 December.
20.10 20.11
ASSETS R R
Non-current assets 450 000 492 000
Net plant and equipment 450 000 492 000
Current assets 523 000 565 000

Inventory 393 000 422 000
Accounts receivable 74 000 81 000
Cash 56 000 62 000
Total assets 973 000 1 057 000
EQUITY AND LIABILITIES

Owner’s equity 671 000 729 000
Share capital 562 000 610 000
Retained profit 109 000 119 000
Non-current liabilities 140 000 157 000

Long-term debt 140 000 157 000
Current liabilities 162 000 171 000

Accounts payable 162 000 171 000
Total equity and liabilities 973 000 1 057 000
Required
You are required to calculate the Cash flow from assets for Bayside Ltd for 2022.
(Refer to the SOCI and SOFP above).
Page 18 of 72
Solution
Operating Cash Flow

R
PBIT 748 000 598 400
+ Depreciation 65 000 65 000
- Taxes 212 100 -221 100
600 900
Capital Spending
R
Ending net non-current assets 492 000
– Beginning net non-current assets 450 000
+ Depreciation 65 000
107 000
Change in Net Working Capital

R
Ending net operating working capital 394 000
– Beginning net operating working capital 361 000
33 000
2011 = 565 000 - 171 000 = 394 000

2010 = 523 000 – 162 000 = 361 000
Cash flow from assets
600 900 – 107 000 – 33 000 R460 900
Page 19 of 72
CHAPTER 3: LONG TERM FINANCIAL
PLANNING AND GROWTH
1. EXPECTED OUTCOMES
• What is financial planning?
• Objectives of financial planning
• Financial planning models
2. WHAT IS FINANCIAL PLANNING?

It is a process of framing financial policies in relation to procurement, investment and
administration of funds of the business.
Objectives of financial planning

• To systematically think about the future of the business
• Anticipate possible future problems, so that actions= may be taken to avoid them
• Establish guidelines for change and growth
Financial planning models

Sales forecast • Starting point of almost all financial plans
• Usually externally supplied like by sales or marketing
departments
• Should be checked by finance department
Pro Forma Statements This includes Income Statement, balance sheet, cash flows
Asset requirements Projected balance sheet indicates changes in fixed assets
and net working capital required to meet sales forecast
Financial requirements Result of sales forecast and dividend policy indicates
amount of new financing required, internal or external
The plug Financial policy will decide how new financing will be raised,
e.g., debt or equity
Economic assumptions This includes rates of inflation, interest, exchange, and tax.
Page 20 of 72
Source: V. Yearwood (Financial management 3 notes)
Percentage of sales approach

The percentage of sales method is a financial forecasting method that businesses use to
predict their sales growth on an annual basis.
Illustrative example 1
PENDERERE COMPANY
INCOME STATEMENT
Present year % of sales Pro Forma

Sales 1 200 000
Costs 400 000
Profit before tax 800 000
Taxes (29%) (232 000)
Net profit after Tax 568 000
Dividends 340 800
Addition to retained profit 227 200
• Penderere company has projected a 30% increase in sales.
• Costs are not proportional to sales
Required:
1.1 Generate a pro forma (projected) income statement
Solution
1.1
Present year % of sales Pro Forma
Sales 1 200 000 30 1 560 000
Costs (400 000) (400 000)
Profit before tax 800 000 1 160 000
Taxes (29%) (232 000) (336 400)
Net profit after Tax 568 000 823 600
Dividends (340 800)
Addition to retained profit 482 800
Source: V. Yearwood (Financial management 3 notes)
The most recent financial statements for Tsikadzedu company are shown below:
Page 21 of 72
INCOME STATEMENT
R
Sales 3 000 000
Costs (1 950 000)
Profit before tax 1 050 000
Taxes (304 500)
Net profit 745 500
BALANCE SHEET
R
Equity 10 000 000
Long-term debt 4 000 000
Capital employed 14 000 000
Fixed assets 9 000 000

Net working capital 5 000 000
Net assets 14 000 000
• Net assets and costs are proportional to sales except for taxes and long-term debt
• Tsikadzedu company maintains a constant 50% dividend payout ratio.
• Next year’s sales are projected to increase by 10%.
Required:
2.1 What is the external financing needed
2.2 Revise your equity and liabilities section of the balance sheet after calculating the
required external finance
Solution
2.1
PRO FORMA INCOME STATEMENT
R
Sales 3 300 000
Costs (2 145 000)*
Taxes (334 950)*
Net profit 820 050
Dividends 410 025
Add to retained profit 410 025
*Costs change with sales (proportional)

*Tax rate is 29% of PBT (304 500/1 050 000 x 100%)
Page 22 of 72
PROF FORMA BALANCE SHEET
Equity (10 000 000 + 410 025) 10 410 025
Non-current assets (300% of sales) 9 900 000

Net working capital (167% of sales) 5 511 000
External finance required 1 000 975
*9 000 000/3 000 000 x 100% = 300% x R3 300 000

*5 000 000/3 000 000 x 100% = 167% x R3 300 000
*15 411 000 – R14 410 025 = 1 000 975
2.2
REVISED PROF FORMA BALANCE SHEET
Equity (10 000 000 + 410 025) 10 410 025
Long-term debt (4 000 000 + 1 000 975) 5 000 975
Now, capital employed equals to net assets. Meaning, A = 0 + L
The most recent financial statements for Bonaqua Ltd are shown below:
INCOME STATEMENT
R
Sales 3 000 000 / 0.95% R3 157 895 100%
Costs (1 950 000) (1 950 000)
Profit before tax 1 050 000 1 207 895
Taxes (304 500) 29% (350 290)
Net profit 745 500 857 605
BALANCE SHEET
R
Equity 10 000 000 10 000 000
Fixed assets 9 000 000 (300% x 3 157 895) 9 473 685

Net working capital 5 000 000 (167% x 3 157 895) 5 273 685
Net assets 14 000 000 14 747 370
External 747 370
Loan
Page 23 of 72
Assume that in the above question all information stays the same, except: the company
is currently operating at only 95% of its fixed asset capacity
Required:
3.1 Calculate the full sales capacity
3.2 By what % can current sales increase to full capacity
3.3 Calculate fixed asset as a % of full capacity sales
3.3 What is the external financing needed if the company wants to operate in full sales
capacity?
3.4 Revise your equity and liabilities section of the balance sheet after calculating the
required external finance
Solution
3.1 Full sales capacity
R3 000 000/0.95 = R3 157 895
3.2 By what % can current sales increase to full capacity
Amount increase = R3 157 895 – R3 000 000 = R157 895
% increase = R157 895/R3 000 000 x 100% = 5%
3.3 Fixed asset as a % of full capacity sales
R9 000 000/R3 157 895 = 285%
3.4 What is the external financing needed
PRO FORMA INCOME STATEMENT

R
Sales 3 157 895
Costs (1 950 000)
Taxes@29% (350 290)*
Net profit 857 605
Add to retained profit 857 605
*Tax rate is 29% of PBT
Page 24 of 72
Fixed assets (300% of R3 157 895) 9 473 685
Net working capital (167% of sales) 5 273 685
External finance required 747 370
3.4 Revised equity and liabilities section after required external finance
REVISED EQUITY AND LIABILITIES

Equity (10 000 000 + 857 605) 10 857 605
Long-term debt (4 000 000 + 747 370) 4 747 370
Page 25 of 72
CHAPTER 4: THE COST OF CAPITAL/Business
valuation
1. EXPECTED OUTCOME:
• The Importance of Calculating the Cost of Capital
• The Elements of the Cost of Capital
• The Risk-free Rate of Return
• Weighted Average Cost of Capital (WACC) Basic Assumptions
• Weighted average cost of capital – Return on Equity
• The Dividend Growth (DG) Model Approach
• Advantages of the Dividend Growth Model
• Disadvantages of the Dividend Growth Model
• The Capital Assets Pricing Model (CAPM) Approach
• Advantages of the CAPM
• Disadvantages of the CAPM
• Price Earnings Ratio
• Market to Book Ratio
• Calculate and interpret the various methods used to value shares.
2. COST OF DEBT CAPITAL

Cost of debt capital is the effective rate that a company pays on its current debt. This can
be measured in either before- or after-tax returns; however, because interest expense is
deductible, the after-tax cost is seen most often. This is one part of the company's capital
structure, which also includes the cost of equity.
3. FINANCIAL GEARING
Financial gearing is the level of a company's debt related to its equity capital, usually
expressed in percentage form. Gearing is a measure of a company's financial leverage
and shows the extent to which its operations are funded by lenders versus shareholders.
High financial gearing means that a company places a heavily reliance on debt financing,
while low financial gearing means that the firm is heavily reliance on equity financing.
4. COST OF EQUITY AND DEBT VALUATION METHODS

As it was defined earlier on, cost of equity is the return that equity investors (shareholders
or other forms of owners) require on their investment in the firm.
There are a number of methods of estimating cost of equity but we will use only two:
Dividend Growth Model and Security Market Line (SML).
Page 26 of 72
1. ORDINARY SHARES AND PREFERENCE SHARES
Ordinary Shares
Ordinary shares, a synonym of common shares, represent the basic voting shares of a
corporation. Holders of ordinary shares are typically entitled to one vote per share and
only receive dividends at the discretion of the company’s management.
Preference Shares
Preference shares, more commonly referred to as preferred stock, are shares of a
company’s stock with dividends that are paid out to shareholders before common stock
dividends are issued. If the company enters bankruptcy, preferred stockholders are
entitled to be paid from company assets before common stockholders. Most preference
shares have a fixed dividend, while common stocks generally do not.
Types of Preference Shares
• Redeemable Preference Shares: these shares are a type of preference share. A

company issues them to shareholders and later redeems them. This means the
company can buy back the shares at a later date. Non-redeemable preference shares
do exist, although companies cannot redeem them
• Convertible Preference Shares. The owner of these preference shares has the
option, but not the obligation, to convert his/her preference shares to ordinary shares
at some conversion ratio.
• Cumulative Preference Shares: If a company does not have the financial resources
to pay a dividend to the owners of its preference shares, then it still has the payment
liability, and cannot pay dividends to its common shareholders for as long as that
liability remains unpaid.
• Non-cumulative Preference Shares: If a company pays a scheduled dividend, then

it does not have the obligation to pay the dividend at a later date. This clause is rarely
used.
• Participating Preference Shares: The issuing company must pay an increased
dividend to the owners of preference shares if there is a participation clause in the
share agreement. This clause states that a certain portion of earnings (or of the
dividends issued to the owners of ordinary shares) will be distributed to the owners of
preferences shares in the form of dividends.
Page 27 of 72
• Par Value shares: Public companies attach a rand value, or par value, to each
class of share it issues. The business uses par value to record the shares issued
in the financial records. The actual price received for the stock usually includes an
amount greater than par value. The company records the amount received above
par value as additional paid in capital and this is known as share premium. Par
value never changes.
• Intrinsic Value shares: The intrinsic value of a stock is a price for the stock
based solely on factors inside the company. It eliminates the external noise
involved in market prices.
• Book Value shares: The book value of a share is the total value of the
company’s assets less the total value of its liabilities and then divided by the total
number of shares issued to ordinary shareholders.
• Market Value shares: Buyers and sellers determine the market value of
each share of stock through the prices they're willing to sell for or to pay for each
share.
I. Market value should be the present value of the future cash flows from the
share.
II. Problem is that future cash flows are uncertain, the share has no fixed maturity
and a required rate of return must be obtained.
III. Three different possibilities for future dividends exist;
2. COST OF EQUITY CAPITAL

As it was defined earlier on, cost of equity is the return that equity investors (shareholders
or other forms of owners) require on their investment in the firm.
There are a number of methods of estimating cost of equity but we will use only two:
1. Dividend Growth Model; and
2. Security Market Line (SML).
A. Dividend market value methods
Advantages of the Dividend Growth Model

➢ The dividend valuation model is simple to use.
➢ It allows for the fact that future dividends should grow if profits are re
invested and that shareholders are likely to value their shares according to their
future dividend’s expectations.
Page 28 of 72
Disadvantages of the Dividend Growth Model
➢ The DG method also assumes that the market value of the share is in equilibrium
so that the share price is correct.
➢ Although it allows for the fact that future dividends should grow if profits are
reinvested, and that shareholders are likely to value their shares according to their
future dividend expectations, it assumes that all shareholders behave in the same
way – which is improbable
Where no growth in dividends is expected in the future, we used the formula: Cost of
equity Ke = (D1/P0) + g.
Our calculation assumes that the market price of a share will be the discounted future
cash flows of revenues from that share, and on a constant growth rate in dividends. It is
sometimes called the ‘Gordon Growth model’. (DG Model)
So, for example, if we have a company with shares currently valued by the market at
R800 000, but with a nominal value of R500 000, last declared dividend 15% and an
expected growth rate of 5%, we would have for cost of equity: Re
Current dividend R500 000 x 15% = 75 000
So D1 will be 75,000 x 1.05 = 78,750
Re = (78,750/800,000) + 0.05 = 14.84%
We do not simply relate the 78,750 back to the nominal value of the shares, as we are
trying to find the expected return based on what owners would have to invest now, i.e.
the market value.
Example:
Estimating “g”
The text outlines a number of ways of estimating g. For the purposes of this course I will
expect you only to be able to estimate g by calculating the average of the % change over
the past number of years.
Year Dividends Change in Rands Change in %

2006 R10.00
2007 R12.00 R2.00 20.0
2008 R13.20 R1.20 10.0
2009 R16.50 R3.30 25.0
2010 R14.85 (R1.65) -10.0
2011 R16.48 R1.63 11.0
2012 R17.64 R1.16 7.0
Ave. Growth = 63% / 6 = 10.5%
Page 29 of 72
1. Dividend Growth Model
Using the dividend growth model to determine the price of a share:
Po = Do x (1+g) = D1 ________
(Re – g) (Re – g)
Where Po = Price per share of equity

Do = Dividend just paid
D1 = Next period’s projected dividend
Re = Required return on share = cost of capital
g = Constant growth rate of dividend
If the price of the share is known, then

Re = D1 / Po + g
2. Dividend Zero growth: In this case, P0 = D / r
Where P0 = Present price per share

D = Dividend per share
r = required return
3. Dividend Constant growth:
P0 = D1 / (r - g) (dividend growth model)

Where D1 = dividend expected next year
g = expected growth rate of dividends
4. Non-constant growth
Project cash flows for as long as dividends are expected not to grow at a constant
rate and determine the present value of these cash flows, and add the present
value of constant growth using the dividend model thereafter.
The cost of Preference Shares

The cost of preference shares is simpler to calculate as the dividend is fixed: It
is calculated as:
Rp = D / Po
Rp = Return on preference shares
D = Dividend
Po = Price of share
Page 30 of 72
Illustrative example 1: Share valuation
Shareholder D purchased shares in company S at a price of R78 per share two years
ago. At the end of the current financial year he received a dividend of R12 per share.
The company’s annual financial statements stated that dividends have increased at a
rate of 5% per annum and that future dividends are expected to continue to grow at
the same rate. Shareholder D has a required rate of return (ke) of 20%.
Required
Determine the value per share of Company S at the present time.
Solution
Dividend today = R12
Future dividend in one year’s time (D1) = R12 x 1.05 = R12.60
The dividend rate of required return = 20%
The formula of present value of future dividends to infinity is = D1

Ke - g
Value = 12.60 = R84

(0.20 – 0.05)
Illustrative example 2: Share value and Debt value
Shareholder Job purchased shares in Company YX at a price of R78 per share two
years ago. At the end of the current accounting cycle Job received a dividend of R12
per share.
The company’s annual financial statements stated that dividends have increased at a
rate of 5% pa and that future dividends are expected to continue to grow at the same
rate. Shareholder Job has a required rate of return (Ke) of 20%.
You are required to:-

Determine the value per share of Company YX at the present time.
Solution
We need to determine the dividend in one year’s time (D 1) as well as all future dividends
to infinity.
Dividend today (D0) = R12

Future dividend in one year’s time (D1) = R12 x 1.05 = R12.60
The dividend rate or required return = 20%
The formula of present value of future dividends to infinity is = D1

Ke - g
Page 31 of 72
Where D1 = Dividend in 1 years’ time
Ke = Shareholder’s required return
g = Growth to infinity
Value = 12.6
(0.2 – 0.05)
= R84
Conclusion: The value per share at Company XY is R84.
Security Market Line

This is based on observations of returns and risk in the market:
Re = Rf + Be x (Rm – Rf)
Where Re = Required return on share = cost of capital

Rf = Risk free rate
Be = Systematic risk of investment relative to
average (beta coefficient)
Advantages of Security Market Line

• Explicitly adjusts for risk
• Applicable where dividend growth is not steady
Disadvantages of Security Market Line

• Requires estimates of market risk premium and beta
• Relies on past to predict future
USING THE SECURITY MARKET LINE (SML) APPROACH / CAPITAL ASSET

PRICING MODEL (CAPM)
Re = Rf + Be x (Rm -Rf)
Re = return on Equity
Rf = Risk free rate
Rm = Return on the Market
Be = Beta co-efficient
Beta factor= risks of the investment

The beta factor is ‘the measure of a share’s volatility in terms of market risk’. The beta
factor of the market as a whole is taken to be 1. This means that:
Page 32 of 72
• Results for individual shares which are greater than 1 imply a greater degree of
volatility
• Results which are less than 1 imply a lower degree of volatility.
• It should then be possible to predict what will happen to the return on a share if
there is a change in the market return.
The cost of debt

"The cost of debt can be observed either directly or indirectly as it is simply the
interest rate the firm must pay on new debt." We use the symbol Rd for the
cost of debt
Rd = i x (1 - t)
Rd = return on debt
i = Interest
1 = 100 %
T = tax
The cost of Preference Shares

The cost of preference shares is simpler to calculate as the dividend is fixed: It
is calculated as:
Rp = Do / Po
Rp = Return on preference shares
D = Dividend
Po = Price of share (Market price)
The Weighted Average Cost of Capital

This refers to the weighted average cost of the current mix of debt and equity employed
by the firm. It is important to remember that the weighting is determined using the current
market value of debt.
WACC = (We x Re) + (Wp x Rp) + (Wd x Rd) x (l -t)
We = Weighting of Equity
Wp = Weighting of Preference shares
Wd = Weighting of Debt (Loan)
Taxes and the weighted average cost of capital
In analysing investments we are always concerned with the after tax cash flows;
accordingly we should be using after tax costs in calculating the cost of capital. As
dividends are not tax deductible there is no tax effect on the cost of equity either
preferences or ordinary equity. The interest on debt however is tax deductible. To the
extent then that this interest reduces a company's taxable income and therefore it's taxes
payable, the effective cost of this capital is reduced.
Page 33 of 72
The Importance of Calculating the Cost of Capital
➢ Benchmarking the firm’s return against similar firms in the industry.
➢ Assessing the value creation potential of new projects as compared to the
cost of capital.
➢ It is an important calculation to make as it forms the basis of calculating the value
of the firms
Illustrative example 1 - CAPM

Suppose that the company have the current market return and the risk-free return:
The market return is 12%, the risk-free return is 8%, and the β is 1,4.
Then calculate Re.
Solution
Re = Rf + βE (RM - Rf)
Re = 8% + 1, 4 (12% - 8%)
Re = 8% + 1,4 x 4% (BODMAS rule)
Re = 13, 6%
Exercise 1
The risk free rate of return is 5%
The expected market rate of return is 10%
The beta factor for the company share is 0.7
Required:
Calculate the expected return of the company shares.
5% + 0.7 (10% - 5%)

5% + 0.7 x 5%
5.035%
Nzuza Ltd has provided with the following information:
Number of shares issued 1 000
Nominal value of each share R2
Market price of each share R3
Last declared dividend 8%
Expected dividend growth 4%
Required:
Calculate the cost of equity (Re) using the DG Model
Solution
Step 1 = Current dividend = R2 x 0.08 (R2 X 8%/100%) =
= R0.16
Step 2 = D1
Growth rate is 4%
Page 34 of 72
D1 = D0 x g
= 0.16 x 1.04 R0.16 X 4%/100% = 0.0064 + 0.16 = R0.17
= 0.17
Cost of equity is:

Re = (D1/P0) + g
Re = R0.17 + 0,04
R3
Re = 9.67%
Assume Peiko Ltd has the following capital structure (ignore reserves):
Equity : 5 000 000 R1 ordinary shares, market price currently R1, 70
Preference Shares : 2 000 000 @ R0.50 yielding 10%, market price currently R0.55
Debentures : 2 000 000, 15% debentures, issued at R1, 00, market price
currently R1.08
Bank loan : R1 000 000 12% bank loan
The company have paid a dividend of 20c per share last year and they expect dividends
to grow by 5%. The company tax is 30% pa.
Required:
1. Calculate their cost of capital, using the Dividend Growth Model as your basis for
valuing equity.
2. Rd = Pref, debenture, loan
3. WACC
Solution
Calculation of return for each type of capital
Equity
Re= D1 + g
Po
0.2 x 5%/100% = 0.01 + 0.2 = 0.21
Page 35 of 72
= 0.20 (1 + 0, 05) + 0, 05 Workings [0,21/1,7 = 0,1235]
1,7
= 17,4%
Preference shares
= Do/Po X 100%
(dividends at present is 50c x 10% = 5c)
= R0, 05/R0,55 x 100%
= 9,1%
Rd = i x (1 - t)
9.1% x (100% – 30%)
9.1% x 70%
6.37%
Rd = i x (1 - t)
Debentures (debt) = 15 x (1-TC)
= 15% x 0, 7
= 10.5%
Rd = i x (1 - t)
Loans (debt)
= 12% x (1 – Tc]
= 12% X 0, 7
= 8,4%
First, we need to calculate the overall market value of these investments, by multiplying
the original values by the market price divided by the nominal value in each case, and
totaling.
Ordinary Shares: 5 000 000 x R1.7/R1 R8 500 000
Preference 2 000 000 x 0.55/0.50 R2 200 000
Debentures: 2 000 000 x1.08/R1 R2,160,000
Bank Loan: R1 000 000 R1,000,000
Total market value R13 860 000
Now let’s find the proportion of this total represented by each type of capital:
Page 36 of 72
Proportion
Equity: 8 500 000/13 860 000 = 0.6133
Preference: 2 200 000/13 860 000 = 0.1587
Debentures: 2 160 000/13 860 000 = 0.1558
Bank loan: 1 000 000/13 860 000 = 0.0722
1.0000
Rate of Return Proportion Unit Cost
Equity: 17,4% x 0,6133 = 10.67

Preference shares: 6,37% x 0, 1587 = 1.01
Debentures: 10.5% x 0, 1558 = 1.64
Loans 8,4% x 0,0722 = 0.61

WACC = 13.93%
Exercise 2
Nozi Ltd has the following capital structure:
Equity 2 000 000 R2 ordinary shares, market price R2, 50
Preference 1 000 000 12% R1 preference shares, market price R1, 20
Reserves R1 500 000
Bank loan R500 000 15% bank loan
Debentures R1 750 000 16% debentures, market price R110 (issued at R100).
The current and expected future rate of ordinary share dividend is 20%.
Required:
If the company tax rate is 33%, what is the weighted average cost of capital?
SOLUTION
1. Calculate cost of capital

Equity = DG Model
Do/P0 x 100%
Or D1/Re - g
Page 37 of 72
(R2 x 0.2)/R2.5 x 100%
R0.40/R2.5 X 100%
Re 16%
Pref-shares
Do/P0 x 100%
R0.12/R1.20 x 100%
10%
Rd = i x (1 – t)
Rd = 10% x (100% - 33%)
Re = 6.7%
Debentures = 16%
Rd = i x (1 – t)
Rd = 16% x (100% - 33%)
Rd = 10.72%
Loan = 15%
Rd = 15% x (100% – 33%)

Rd = 10.05%
2. Convert capital into market values

3. Proportions
Proportions
Equity (2 000 000 x R2.5/R2) =R2 500 000 0.4082
Pref-shares (1 000 000 x R1.2/R1) =R1 200 000 0.1959
Debenture (17 500 x R110/1) =R1 925 000 0.3143
Loan =R500 000 0.0816
Total market price =R6 125 000 100%
4. Apply calculations into WACC table
Cost of capital Proportions Cost Unit

Equity 16% X 0.4082 6.53
Pref-shares 6.7% X 0.1959 1.31
Debentures 10.72% X 0.3143 3.37
Loans 10.05% X 0.0816 0.82
WACC 12.03%
How do you value the business?
Page 38 of 72
DG model (Use shares to value the business)
Po
Re
CAPM = Considers both the required rate of return and market risk
Choice Company A Company B

(DG)
Re 20% 50%
(CAPM)
Re 20% 30%
Risk (5%) (15%)
15% 15%
Assets
ASSETS:
Non-current
Land and Buildings
Furniture
Fixed investments
Current
Inventory
Debtors
Cash
Total assets R5 000 000 R5 000 000
EQUITY & LIABILITIES
Equity:
Ordinary share capital 200 000 @R1 R200 000 R12 = 2 400 000
Undistributed profit R210 000
Non-current Liabilities 350 000

Debentures 100 000
Pref-share capital 200 000
Loan 50 000
Current liabilities 15 000

Creditors 10 000
SARS 5 000
Page 39 of 72
PRICE EARNINGS RATIO (EPS)
This is a return that is attributable to ordinary shareholders (after allowing for payment of
interest on loans and debentures, taxes, and preference dividends).
Income statement
Sales
COS
Gross profit
Expenses
PBI&T
Interest
PBT
Tax
Net profit after tax 500 000
Pref dividends (250 000)
Earnings 250 000
Ordinary dividends (R40 000)
Retained profit 210 000
EPS
Earnings/Total No. of Ord shares issued
R250 000/200 000
R1.25
Decision of directors for ord. dividends:
Pay R0.20 per ordinary share

Assume: Issued ord. shares = 200 000
The ratio seeks to test the relationship between a share price (ordinary share) and its return.
1994 2020
Nominal Market (Po)
Price per share R1 R12
EPS R1.25 R1.25

R0.25 -R10.75 (loss)
Market Value
Buyers and sellers determine the market value of each share of stock through the prices they're
willing to sell for or to pay for each share.
The market value is a consensus value of all traders.
Page 40 of 72
Book value
The book value of a share is the total value of the company’s assets less the total value of its
liabilities and then divided by the total number of shares issued to ordinary shareholders.
Total assets 5 000 000

-Total liabilities (365 000)
Book value 4 635 000
DG Assets Market book value

Po x No. shares
R12 x 200 000
R2 400 000 R5000 000 R1 500 000 R4 635 000
200 000 200 000 200 000 200 000
Share price R12 R25 R7.5 R23.18
Calculate share value using each method
Market to Book Ratio
Formula =
Market price per share VS Book value per share
Book value Market
A-L R4 635 000 R7 500 000
Ratio R23.18 R37.50
Sold at Market value R7 500 000

Book value (R4 635 000)
Capital Gain R2 865 000
Tax 30% (859 500)
Into your pocket R2 005 500
Page 41 of 72
CHAPTER 5: DIVIDENDS AND DIVIDEND POLICY
• The Clientele Effect
• Dividend Policy
• Types of Dividends
• Real World Factors affecting a High Dividend Payout
• Practical Issues in respect of the Payment of Dividends
• Signaling
• The Dividend Decision
• The Residual Dividend Approach
• Share Repurchase: An alternative to Cash Dividends
• Share splits and scrip dividends
2. THE CLIENTELE EFFECT

The clientele effect implies that an investor in need of current income will invest in a
company that has a high payout ratio. Whereas an investor not interested in current
income will prefer shares in a company with low dividend pay-outs, but with high capital
growth potential.
3. DIVIDEND POLICY
The 4 reasons as to why Dividend Policy is to be regarded as relevant
a. “A bird in the hand is worth two in the bush” If a dividend is declared, you are quite
certain of receiving it. This is not necessarily so for a capital gain.
b. The signaling process: this is when the dividend announcement is used to

communicate information to the shareholders about the company.
c. The tax preference explanation. In South Africa, dividends and capital gains are
subject to capital gains tax (CGT). Because capital gains tax is delayed until the
shares are sold, investors may prefer capital gains to dividends.
d. The agency explanation: This theory states that if funds are retained in the
company, it may not always be used optimally. Paying larger dividends thus
reduces the internal cash flow subject to management discretion.
Before paying Ordinary dividends

Directors must be certain that the business will continue to operate as a going-concern
Financial status of the Co. is satisfactory
Page 42 of 72
Profit 500 000
Cash in the account R200 000
Pay ord div R200 000
Terminology
Dividend: This is a payment made out of a company’s profits to its owners. Dividends
can be paid as cash or further shares.
Ordinary share capital of 1000 @R2 each = R2000

Amount is R5000
Dividend: Cash R5000
Share capital R5000 + R2000 = R7000
Types of dividends
A regular cash dividend: This takes place once or twice a year. Once in mid-year if
earnings are already healthy. This is called an interim dividend. And one at year end. This
is called a final dividend.
Liquidating Dividend: is declared when the business is sold off.
Before paying dividends = Directors must ensure that the Co. is Going-Concern
= Co. must continue operating
Cash R200 000 CA-CL

Profit R500 000
Decids= Div of R50 000
Special Dividend: paid as a result of an unusual event, perhaps the sale of a part of the
business.
Homemade Dividends: if you don’t receive dividends you need, then you sell off a
portion of that investment (shares) to compensate for the shortfall in dividends not
received.
Page 43 of 72
Expected DIV R500
Ordinary share capital of 1000 @R2 each = R2000
But the company is unable to pay a Div you’re expecting.
R2000 – R500 = R1 500
Example
If an investor expected a dividend of R5 000 at end of the year and R6 000 following year,
but only received R2 000 in year one, then the investor will sell shares to the value of
R3 000 to compensate for this loss in dividend. In the same way if an investor received
more than he expected in year one, then she may use the additional sum of dividends to
buy more shares in the company in order to compensate for a possible loss of dividend
next year.
4. FACTORS FAVORING A LOW DIVIDEND PAYOUT
SA Tax system
Progressive = The higher you earn, the higher you pay tax
Jaca Diya
Gross Salaries R50 000 R70 000
Dividends R20 000 R20 000
GROSS INCOME R70 000 R90 000
Tax 15% 20%
Tax 10% 15%

Tax amount (R5000) (R10 500)
Take home R4 5000 R59 500
Taxes
Investors that are in high marginal tax brackets might prefer lower dividend payouts.
Flotation Costs
If the company has a high dividend payout, it will be using its cash to pay dividends
instead of investing in projects. If the company decides to issue new shares in order to
fund projects, one must know that there are costs associated with issuing new shares. If
the company had paid a lower dividend and used the cash on hand for projects, it could
have avoided at least some of the flotation costs.
Page 44 of 72
Tax and Other Benefits from High Dividends
Corporate investors
At least 70% of dividends received from other companies does not have to be included
in taxable income.
Signaling
Dividend signaling is a theory that suggests that a company announcement of an increase
in dividend payouts is an indication of positive future prospects.
It is noticeable that, in a hostile takeover bid, the target company often announces a
higher dividend level in its efforts to prevent its shareholders from accepting an offer from
a predator.
Impact of changing dividends

Share prices decline when dividend decreases. Likewise, share price increases on
increased dividends because market reacts to managements signal about the future
2019 2020 2021
Dividend per share R15 R10 R25

Share price R7 R5 R17
Market entry
The Dividend Decision

1. Firms have longer term target dividend payout ratios.
2. Managers focus more on dividend changes than on absolute levels.
3. Dividends changes follow shifts in long-run, sustainable levels of earnings
rather than short- run changes in earnings.
4. Managers are reluctant to make dividend changes that might have to be
reversed.
Thus they prefer to select sustainable levels of dividends.
Residual Dividend Approach

A residual dividend policy is one where a company uses leftover equity to fund dividend
payments.
This is done after funding is set aside for projects that they wish to engage in.
Stock Repurchase: An Alternative to Cash Dividends

A stock repurchase occurs when a company buys back its own shares. They may do this
via:
If the company needs cash: Sell shares

Borrow money
Cash required = R100 000
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People
Decided to issue shares = 100 000 @R1 each
Equity:
Ordinary share capital 50 000@R1 each R50 000
Unissued shares 50 000
Repurchase:
50 000 shares = refund 50 000 @R1
O L
Nyembe
Holds 1000 shares @R2 each R2000
Entitled to R5000 as a dividend
Options Take money re-invest as share capital

Cash dividend R5000 (eat)
R5000
Holds 1000 shares @R2 each R2000

Re-invested cash R5000
Total share capital R7000
Scrip Dividends:
A scrip dividend is a dividend that is not paid out in cash. Shareholders are given
additional shares in lieu/Instead of their shareholding (Dividend). There are no cash flow
implications. What actually occurs is that funds are transferred from the distributable
reserves account to the share capital.
Illustrative Example 1
The owner’s equity accounts for Nonto Ltd are shown below:
Ordinary shares capital (par value R1) R 10 000 + 10 000 SHARE

Share premium R180 000 +
Retained income R586 500 - R25 X 1000 =R25000
Shareholder’s equity R776 500
• If Nonto Ltd shares sell currently for R25 per share and a 10% scrip dividend is
declared, how many new shares will be distributed?
• Show the effect on the equity accounts.
• If Nonto Ltd declared a 25% scrip dividend, how would the accounts change?
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Solution
Shares in hands of shareholders at present is 10 000.
New shares will amount to 1 000 (10 000 X10%)
Since the par value of the new shares is R1, the share premium per share is R24.
The total share premium is therefore:
Share premium on new shares = 1 000 X R24 = R24 000
Shareholders’ equity R
Ordinary share (R1 par value) (R10 000 +R1000 [1000 X R1) 11 000
Share premium (R24 x 1000 +180 000) 204 000
Retained profits 561 500
R776 500
Workings
Retained earnings = (R586 500 – R1000 – R24000)
R25
R1 - Share capital +
R24 - PREMIUM +
BUSINESS OWNER
Contributed (CAPITAL) R100 000 + R50 000 =R150 000
Transfer of R50 000 from one acc to another
NO CASH HAS BEEN PAID OUT
Don’t give it to me, rather re-invest as further contribution
RULE: DIVIDENDS ARE PAID OUT OF PROFIT
PREF-DIVIDENDS (XXXXX)
RETAINED PROFIT
ORD DIVIDENDS (XXXX)
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CHAPTER 6: CAPITAL BUDGETING AND
PROJECT EVALUATION
• Steps in the Capital Budgeting Process
• Aims of Appraising Projects
• Types of Investment Projects
• Payback Period
• Advantages of the Payback Period
• Disadvantages of the Payback Period
• Accounting Rate of Return (ARR)/Average Accounting Return (AAR)
• Net Present Value (NPV)
2. CAPITAL BUDGET
This section relates to the capital budgeting decision, also called strategic asset
allocation. "An investment is worth undertaking if it creates value for its owners" (Firer,
p249). Techniques are introduced for analyzing capital investments to determine whether
or not they create value for the owners. For each technique you must understand:
• How to apply the technique to a particular investment decision problem.

• How to advice, based on the results of your calculations, whether or not an investment
is worthwhile.
• What the advantages and disadvantages of the technique are.
3. STEPS IN THE CAPITAL BUDGETING PROCESS

The capital budgeting process consists of the following six steps as:
a. Identify all possible investment alternatives. In this way due scrutiny and attention is
given to all possible options.
b. Determine the relevant cash flows associated with each of the possible investment
alternatives.
c. Determine the company’s cost of capital (this is discussed in greater detail in the
chapter headed Cost of Capital
d. Evaluate the various projects. Various investment appraisal methods are used in order
to test financial feasibility.
e. Make the investment decision. This is done when all project cash flows (inflows and
outflows) have been ascertained.
f. This is the final step and known as the follow up step. This means that every project
is evaluated in order to ensure value creation.
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4. TYPES OF INVESTMENT PROJECTS
Replacement or expansion
Replacement: acquisition of asset to maintain existing production; may result in cost

savings. Generally cash flows resulting from savings are fairly certain. Expansion: may
be to increase volumes of existing lines or to add new product lines. Estimated demand,
especially of new lines, may be difficult, resulting in less certainty of cash flows.
Independent and mutually exclusive projects
Independent projects: acceptance of one project does not affect acceptance of another
independent project – either or both may be accepted. Mutually exclusive projects:
acceptance of one means other cannot be accepted.
Divisible and indivisible projects
Divisible project may be split into number of separate parts, each capable of being
undertaken on its own. Indivisible project cannot be split – either whole project must be
undertaken or not at all.
5. CAPITAL RATIONING
Reasons for capital rationing
• Normally firm will accept all projects which meet investment criteria
• May require additional funds leading to loss of control
• Sometimes top management imposes capital rationing on middle management as a
control, and to avoid excessive requests for funds.
Investment / Project Ranking
To decide how to allocate rationed available funds, projects must be ranked in some way.
Using NPV or IRR as a basis for ranking does not take into account size of initial
investment, which is important under capital rationing
6. PROJECT CASH FLOWS
The difference between a firm’s future cash flows with a project and without the project is
relevant in making a decision whether or not to invest in the project. Any change in a
firm’s overall cash flow directly resulting from investment in a project is a relevant cash
flow. This means that all incremental cash flows resulting from the project are relevant.
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Stand-Alone Principle
Evaluation of a project is based on the project’s incremental cash flows. There is no need
to calculate all the cash flows of a firm, with and without the project; only the incremental
cash flows need be focused on.
Incremental Cash Flows

The cost added in the project.
Sunk Costs
Sunk cost is the type of cost that have already been paid or incurred, therefore cannot be
changed and will not lead to incremental cash flows. Therefore, must not be considered
in investment decisions.
Opportunity Costs
Opportunity costs refer to benefits that must be given up as a result of taking on the
project. They results in a reduction in overall cash flow as result of the project (incremental
cash flow is negative or a cash outflow).
Side Effects / Erosion
Investing in a project may lead to reduction in sales of other products, resulting in a

reduction of cash flow: called erosion.
Net Working Capital (NWC)
Unless all transactions are cash (unlikely), any new project will have an operating and
cash cycle. This means that a firm will have to invest in net working capital for the project,
as well as fixed assets. NWC requirements may increase as the project progresses, and
then start to reduce towards the end of the project, finally decreasing to zero at the end
of the project.
NB: A project can only be considered complete when all assets have been scrapped or
disposed of, and all NWC converted to cash.
Financing Costs/ Cost of Capital {Dividends + Interests}
Financing costs such as interest or dividends paid must not be included in project cash
flows, because these are rewards to providers of capital and are not generated by the
assets / operations of the project. The tax effect of interest paid must also not be
considered.
Inflation
Effects of expected inflation on future cash flows should be allowed for, because investors
will have included an expectation of inflation in their required rate of return.
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Tax Effects
The after-tax cash flows must be determined. This requires determining both the amount
of tax that results from the profits earned by the project, and the timing of the resulting tax
payments.
Other Issues / Government Intervention
Any incentives received from government or other organizations, in the form of grants,
capital allowances, tax credits, etc. must be taken into account.
7. DETERMINING PROJECT CASH FLOWS FROM PRO-FORMA FINANCIAL

STATEMENTS
• Pro-Forma Financial Statements
Working from estimates of future sales, costs, and investments for the life of the project,
projected income statements and balance sheets are prepared, for the entire project, and
at convenient points during the project, e.g. annually. Statements should be in
summarized form, including only data relevant to the project. The projected income
statements should include depreciation so that tax can be calculated, but not interest /
dividends. Balance sheet would only comprise the Employment of Capital (Net Assets)
section.
• Project Cash Flows
From these pro-forma statements, the project cash flows can be determined, in the same
way that cash flow for the entire firm is calculated. Project Operating Cash Flow = Project
Profit Before Interest & Tax + Depreciation – Tax. Project Cash Flow = OCF +/– Changes
in NWC – Net Fixed Asset Purchases. From this the total project cash flow for each year
can be calculated and discounted back to net present value, using the required rate of
return, which may be the firm’s weighted average cost of capital, or some other specified
rate. If necessary, another method of evaluating the project may be used, such as
payback period, discounted payback period, average accounting return, or internal rate
of return.
• Depreciation
Depreciation is a non-cash item, but affects cash flow because it is allowable as deduction
in calculating tax. This is called the depreciation tax shield. Because we are only
concerned with the tax effect of depreciation, the amount of depreciation included in the
project income statement should only be that which SARS will allow as Wear and Tear
(SARS' term for depreciation). Where an asset has been depreciated and is later sold for
more than its book value (initial cost less accumulated depreciation), tax will have to be
paid on the profit thus earned. This must be taken into account in calculating the project
cash flow.
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8. INVESTMENT CRITERIA
8.1 Net Present Value (NPV)
NPV is the difference between an investment's market value and its cost.
Method of calculating NPV
• Estimate initial or start-up costs.

• Estimate future cash in- and outflows expected as a result of the investment, and the
periods over which these cash flows will occur.
• Calculate the present value of future cash flows using an appropriate discount rate.
• Calculate the difference between the present value of the future cash flows and the
initial cost. This is the net present value.
• Identify whether the net present value is positive or negative.
Basic decision rule: "An investment should be accepted if NPV is positive and rejected
if it is negative”.
If NPV is positive the investment adds value, if negative it reduces value.
Advantages of NPV
• Takes time value of money into account

• Uses all cash flows relating to a project
• Theoretically sound method
Disadvantages of NPV
• Can be time-consuming
• Requires a required rate of return to be given or estimated
• Risk differences between projects are not considered
Discount rate
A discount rate is used to determine present values; an appropriate discount rate must
be used, which is usually the rate of return which the firm wants to earn on its investments,
or the market rate on comparable investments.
8.2 Payback Period
Payback period is the amount of time required for an investment to generate cash flows
to cover its initial cost.
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Method of calculating payback period
• Estimate initial or start-up costs.

• Estimate future cash in- and outflows expected as a result of the investment, and the
periods over which these cash flows will occur.
• From the initial investment, subtract the annual cash flows until the balance is zero.
• Add up the number of years for zero cumulative cash flow to be achieved. If in one
year the cash flow is greater than the balance from the previous year, calculate the
proportionate fraction of that year to attain a zero balance.
Decision rule: An investment is acceptable if its calculated payback period is less than
the prescribed number of years.
Disadvantages of payback period
• Time value of money is ignored.

• No objective basis to choose an acceptable number of years as a payback criterion.
• Cash flows after payback are ignored entirely.
• Risk differences are not considered.
Advantages of payback method
• Comparative simplicity and ease of use

• Biased towards short-term projects and liquidity
• Later cash flows are more uncertain, and payback tends to ignore these.
Discounted Payback Period
Discounted Payback Period is the time required for an investment's discounted cash flows
to equal its initial cost.
Advantages & Disadvantages
• Similar to the normal payback criterion, but it takes time value of money into
account.
8.3 Average Accounting Return (AAR)
AAR is the average net profit after tax of an investment divided by its average book
value.
Calculation Method
• Determine the accounting investment value ("book value of assets") at the beginning
and end of each period over the life of the project.
• Determine the expected accounting profits for each period over the life of the
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investment. Accounting profits are usually calculated as operating cash flow (cash
profit after tax) less depreciation.
• Calculate average accounting profit and average investment value over life of
investment. This is normally a simple average.
• Calculate AAR by dividing average accounting profit by average investment value.
• AAR = Average accounting profit x 100%

Investment value 1
• An investment is acceptable if the average accounting return exceeds a target

return.
Advantages & Disadvantages
• Main advantage is ease of calculation

• Main disadvantage: ignores time value of money
8.4 Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV of investment zero.
Calculation Methods
Trial and Error
• Estimate cash flows over life of investment as for the NPV method.
• Then determine NPV of cash flows using different discount rates, until an NPV of
zero is obtained. The discount rate that gives this zero NPV will be the IRR.
• Interpolation
Estimate cash flows and determine several NPV's as above. It selects two discount rates,
one which gives the lowest positive NPV and one which gives the lowest negative NPV.
Determine IRR by interpolating between these two rates.
• Graphical
• Follow the steps as above, and plot the discount rates and NPV's on a graph.
• Where the NPV line crosses the axis is where NPV = 0, therefore this is the IRR.
Decision Rule - if IRR exceeds required or market rate of return then investment is
acceptable.
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Advantages
• Easy to understand: it is "the" rate of return (% profit) of the investment.

• Considers time value of money.
• Relates closely to NPV criterion.
Disadvantages
• Can be difficult to calculate.

• May give multiple answers, especially if some cash flows are negative.
• Does not deal well with mutually exclusive investments.
8.5 Modified Internal Rate of Return (MIRR)
While the internal rate of return (IRR) assumes the cash flows from a project are
reinvested at the IRR, the modified IRR assumes that positive cash flows are reinvested
at the firm's cost of capital, and the initial outlays are financed at the firm's financing cost.
Therefore, MIRR more accurately reflects the cost and profitability of a project.
Illustrative Example 1
An initial outlay of R2 200 is required and cash inflows of R600 and R900 accrue in years
1 and 2 respectively.
Required:
Based on the payback period, should the project be accepted or not? Use both non-
cumulative and cumulative cash flow methods to support your response.
Solution
Non-cumulative method
Year Cash inflow (p.a) Cash outflow Balance
1 R600 -R2 200 -R1 600
2 R900 -R1 600 -R700
R1 400 -R700 (paid in full) R700
• The company will not be able to pay the initial cost even up to the last day of the
project.
• To calculate the exact period, we need to make an important assumption: that revenue
is earned equally throughout the period. A workable formula is:
= years before full recovery + unrecovered cash flow at beginning of year X 365
Cash flow during the year
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Our answer therefore is
= 2 years + [700/1400 X 365]
= 2 Years and 182.5 days
Cumulative method
Year Cash flow (p.a) Accumulated Cash Flow
1 R600 R600 balance
2 R900 R1 500 balance
3 R1 400 -R700
• The company will not be able to pay the initial cost even up to the last day of the
project.
Gabbazy enterprise have just made an investment of R420 000 in a state of the art wheel
alignment machine, details of which are below:
Bought a machine R420 000

Expected useful life 6 years (straight line depreciation)
Salvage value R120 000
Cost of Capital 10% pa (Interest + Dividends)
Tax rate 30% pa
Expected cash flows is as follows:
Year Cash inFlows
R
1. 66 000
2. 96 000
3. 126 000
4. 181 000
5. 68 000
6. 50 000
Required:
2.1 Based on the payback period, should the project be accepted or not?
(Use a cumulative cash flow method to support your response).
2.2 List advantages and disadvantages of the payback period method.
Page 56 of 72
Solution
2.1
Year Cash Flow Cumulative Cash Flow Non-cumu..
0 (R420 000)
1 66 000 66 000 (354000)
2 96 000 162 000 (258000)
3. 126 000 288 000 (132000)
4. 181 000 469 000 (stop)
5. 68 000
6. 50 000
Payback is: 3 years and [132 000/181 000 X 365]
3 years and 7 months
3 years and 266, 18 days (You may round off to 267 days)
2.2
Advantages of the Payback Period
• It is easy to understand and calculate.
• It adjusts for uncertainty of later cash flows.
• It serves as a criterion to measure liquidity, because the quicker the initial investment
is paid off, the earlier the generated cash is available for alternate use.
Disadvantages of the Payback Period

• It ignores the time value of money.
• It is very subjective.
• It insists on a cut off period
• It ignores cash flows beyond the cut off period
• It does not consider the cost of capital in any way.
• It makes no distinction between projects of different sizes with different capital
requirements and with different lifetimes.
Accounting Rate of Return (ARR)/Average Accounting Return (AAR)

The accounting rate of return method takes the average accounting profit that the
investment will generate and expresses it as a percentage of the average investment in
the project as measured in accounting terms. A flawed approach to making a capital
budgeting decision is the ARR. It requires the following data to be available:
a. Average profit = Total profits/no of years
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The Formula
ARR = Average annual profits x 100%

Investment 1
The Decision Criteria

To decide whether the return is acceptable, we must compare the percentage with the
minimum required by the business. If the firm has a target ARR less than the percentage
achieved, then this investment is acceptable, otherwise not.
Gabbazy enterprise have just made an investment of R420 000 in a state of the art wheel
alignment machine, details of which are below:
Machine cost R420 000

Expected useful life 6 years (straight line depreciation)
Salvage value R120 000
Cost of Capital 10% pa
Tax rate 30% pa
ARR target 20%
Expected net cash inflows are as follows:
Year Cash inFlows

R
1. 66 000
2. 96 000
3. 126 000
4. 181 000
5. 68 000
6. 50 000
Required:
1.1 Calculate the ARR.
1.2 What are the advantages and disadvantages of ARR?
Solution
1.1
Since net cash inflows do not take depreciation into account, we still have to take it out
from Net cash inflows.
Why?
=Net profit (Accounting profit)
=Subtract depreciation from net cash inflows
Page 58 of 72
Year Cash inFlows
R
1 66 000
2 96 000
3 126 000
4 181 000
5 68 000
6 50 000
Net cash inflows 587 000
Calculate net profit

Subtract depreciation from net cash inflows
Net cash inflows R587 000 – R300 000 = R287 000/6 = R47 833
R420 000 –R120 000/6yrs

R50 000 pa x 6 = R300 000
OR
ARR = Average annual profits x 100%

Investment 1
NET CASH INFLOWS R587 000/6yrs = R97 833 pa
Depreciation = R420 000 – R120 000/6 = (R50 000)
= R47 833
ARR = Average Profits/Investment X 100%
= R47 833/R420 000 x 100%
ARR = 11.39%
Is this acceptable or not?
=Not sure
Unless I know Co. target
It is not acceptable
1.2
Page 59 of 72
Advantages of the ARR
• It is relatively easy to calculate
• Data that’s needed is easily available in the annual financial statements
Disadvantages of the ARR

• It ignores the time value of money
• The salvage value may not be realistic
• It is based on accounting profits (these are merely book entries), not on cash flows
(which are the lifeblood of any business).
• It is not a rate of return in any meaningful sense
Messi Motors have just made an investment of R420 000 in a state of the art wheel
alignment machine, details of which are below: Expected useful life 6 years (straight line
depreciation)
Salvage value 120 000
Cost of Capital 10 %
Tax rate 30%
Expected cash inflows are as follows:
Year Cash Flows
R
0 (420 000) Planning phase (Acquire needed resources)
1 66 000
2 96 000
3 126 000
4 181 000
5 68 000
6 50 000
Required:
Calculate the NPV of this project and state whether the project should be accepted or
rejected.
1/(1 + i)t
1/(1 + 0.1)1
1/1.1= 0.9090=0.8264=0.7513=0.6830=
Solution
CoC
Year Cash Flows DF (10%) Discounted Cash Flow
0 (R420 000) 1 (420 000) CASH OUTFLOW

1 66 000 X 0.9091 60 001
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2 96 000 X 0.8264 79 334
3. 126 000 X 0.7513 94 664
4. 181 000 X 0.6830 123 623
5 68 000 X 0.6209 42 221
6 50 000 X 0.5645 28 225
120 000 X 0.5645 67 740
PV 495 808 CASH INFLOWS
NPV 75 808
The project should be accepted as NPV is positive.
Should the Co. set a target = then should consider that the target in your decision
If targeted NPV was R100 000
Notes
a. The PVIF tables are used at a factor of 10%.
b. The factors can be worked out using the formula PV = 1/(1+r)t
c. Cash flows must be after tax. If it is before tax, it must be converted to after tax.
Advantages of NPV
1. It accounts for the time value of money.
2. It is logically consistent with the company’s goal of maximising shareholder wealth.
3. It is relatively easy to calculate.
4. It uses all the cash flows of a project and discounts them consistently.
5. It is realistic in outlook.
Disadvantages of NPV
1. Fixed assumptions are made around the variables affecting project cash flows such
as: exchange rates, selling prices, inflation.
2. NPV’s major problem is that it relies crucially on predicting the future.
Illustrative example 3, IRR
Messi Motors have just made an investment of R100 000 in a state-of-the-art wheel
alignment machine, details of which are below: Expected useful life is 2 years (straight
line depreciation)
Year Cash Flows DF (30%) Discounted Cash Flow

R R
0 (100 000) 1 (100 000)
1 66 000 0.7692 50 767 Profit
2 96 000 0.5917 56 803 Profit
NPV 7 570
Page 61 of 72
Required:
2.1 Define the term ‘IRR’.
2.2 Calculate IRR for the company.
Solution
2.1 IRR definition
Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV)
of a project zero.
2.2
Step 1 = Current NPV is R7 570 and is positive
Step 2 = Guess a rate that will make NPV zero
Step 3 = If NPV is positive then try the higher rates, if negative try lower rates
Try and error method

Try Try
Year Cash Flows 30% 36% 37%
R
0 (R100 000) (R100 000) (R100 000) (R100 000)
1 66 000 50 767 48 530 48 173

2 96 000 56 803 51 903 51 148
R107 570 R100 433 R99 321
R7 570 R433 (R679)
Therefore, IRR is between 36% and 37% and it can be calculated as follows:
36% + 37% = 36.5%

2
Exercise 1
Part A
R Ltd is deciding whether to launch a new product. The initial outlay for the new
product is R18 000. The forecast possible annual cash inflows and their associated
probabilities are shown below:
Probability Year 1 (R) Year 2 (R) Year 3 (R)
Optimistic 0.20 10 000 12 000 9 000

Most likely 0.50 7 000 8 000 7 600
Pessimistic 0.30 6 400 7 200 6 200
The company’s cost of capital is 15% per annum.
Page 62 of 72
Assume the cash inflows are received at the end of the year and that the cash inflows
each year are independent.
The expected NPV for the project is?
A (R165)
B (R582)
C (R5 660)
D R10 430
E R22 286
In order to be able to calculate the NPV, we must first calculate the expected cash flow
at the end of each of the three years.
Expected value of cash flows:

Probability 0.20 0.50 0.30 Totals
Cash inflows Y1 10 000 7 000 6 400 7 420
Cash inflows Y2 12 000 8 000 7 200 8 560
Cash inflows Y3 9 000 7 600 6 200 7 460
Year cash inflows DF@15% Discounted Cash Flow

0 (R18000) x 1 (R18000)
1 R7 420 x 0.8696 6 452
2 R8 560 x 0.7561 6 472
3 R7 460 x 0.6575 4 904
PV 17 828
NPV (R172)
PART B
A company is appraising an investment project which has the following expected cash
flows:
Time Cash flow per annum

R
0 (35 200)
1-4 5 280
5-8 12 320
10 (17 600)
The company’s cost of capital is 8%.
What is the NPV for the project?
A (R4 252)
B R4 137
C R12 287
D R12 401
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Year Cash inflow DF@8% Discounted Cash Flow
0 (R35 200) x 1 (R35 200)

1-4 R5 280 x 3.312 R17 487
5-8 R12 320 x 2.4346 R29 994
10 (R17 600) x 0.4632 (R8 152)
PV R39 329
NPV R4 129 Positive
1 5 280 x .9259 =
2 5 280 x .8573 =
3 5 280 x .7938 =
4 5 280 x .7350 =
3.312
5 12 320 .6806
6 12 320 .6302
7 12 320 .5835
8 12 320 .5403
2.4346
Reminder:
Do still remember time value of money techniques?
=PV single investment
=PVA repetitive investments (Annuities)
Exercise 2: NPV, Payback and IRR

Galatians Corporation is considering investing in one of two alternative capital
projects. Estimated profits relating to the two alternative projects are as follows:
Project Project
Malaki Matthew
Initial cash investment R20 000 R20 000

Expected economic life 5yrs 5yrs
Salvage 0 0
Annual profit (loss) R R
End of: Year 1 (20 000) 18 000

Year 2 5 000 18 000
Year 3 10 000 18 000
Year 4 60 000 18 000
Year 5 70 000 18 000
Page 64 of 72
The company estimates that its cost of capital is 12%. Depreciation is calculated on
a straight-line basis.
REQUIRED:-
2.1 Calculate the Net Present Value of each project (NPV). (Round off amounts to
the nearest Rand)
2.2 Based on your calculations in question 1, which project should be chosen? Why?
2.3 Calculate the Payback Period for project Malaki using the discounted profit per
year? (non-cumulative method)
2.4 Calculate the Internal Rate of Return (IRR) for project Malaki.
2.1
Malaki
Years Net profit DF@12% Discounted profits
Year 0 (R20 000) 1 (R20 000)
Year 1 (20 000) 0.8929 (17 858)
Year 2 5000 0.7972 3 986
Year 3 10 000 0.7118 7 118
Year 4 60 000 0.6355 38 130
Year 5 70 000 0.5674 39 718
PV 71 094
NPV 51 094
Matthew
Years Net profit DF@12% Discounted profits
Year 0 (R200 000) 1 (R20 000)
Year 1 18 000 0.8929 16 072
Year 2 18 000 0.7972 14 350
Year 3 18 000 0.7118 12 812
Year 4 18 000 0.6355 11 439
Year 5 18 000 0.5674 10 213
PV 64 886
NPV 44 886
Page 65 of 72
Workings
PV = R64 886 (18000 x 3.6048)
Cost = (R20 000)
NPV = R44 886
2.2 Based on your calculations in question 1, which project should be chosen? Why?
Which one is to be chosen?
Malaki project = R51 094
Matthew project = R44 886
The company criteria for project selection is NPV
The rule is that if NPV is positive, it can be accepted with exceptions and if it is
negative we reject.
Decision: Accept project Malaki.
Why?
Malaki has the positive and highest NPV compared to Matthew.
2.3 Calculate the Payback Period for project Malaki using the discounted profit per
year? (non-cumulative method)
Years Amounts Balance Period

0 (R20 000)
1 (17 858) (2 142) 1
2 3 986 1 844
3 7 118
4 38 130
5 39 718
Payback period 1 year 5 months
1 year + 0.5 or 5 months (2 142/3 986)
Accept or reject is not asked in the question.
Page 66 of 72
However, if it was required, you would answer as follows:
Decision:
Initial cost will be recovered within 1.5 years before the end of the project
Therefore, the project should be accepted with an exception of the company’s payback
target period.
Cumulative
Years Amounts Balance Period
0 (R20 000)
1 (17 858) (17 858) 1
2 3 986 1 844
3 7 118
4 38 130
5 39 718
2.4 Calculate the Internal Rate of Return (IRR) for project Malaki.
What is IRR?
Is the rate that makes NPV zero
What is NPV for Malaki?
(R128 906)
What was the used?
12%
Since NPV is negative, how should be we calculate IRR – Trial and Error rule?
The golden rule is as follows:

1. If NPV is negative = IRR trial and error rate should start with the rate
lower than of NPV
2. If NPV is positive = IRR trial and error rate should start with the rate
higher than of NPV
Meaning of this:
NPV is positive and have used 12%
Page 67 of 72
Trial and error
Rate to be use is anyone that is above 12%
Years Net profit Try41% Try40%

R R R
Year 0 (20 000) 1 (20 000) 1 (20 000)
Year 1 (20 000) 0.7092 (14 184) 0.7143 14 286)
Year 2 5000 0.5030 2 515 0.5102 2 551
Year 3 10 000 0.3567 3 567 0.3644 3 644
Year 4 60 000 0.2530 15 180 0.2603 15 618
Year 5 70 000 0.1794 12 558 0.1859 13 015
PV 19 636 20 542
NPV (364) 542
When we use 40% NPV is slightly positive and if use 40% it is slightly negative
We cannot move either up or down at this point.
This means that IRR is between 40% and 41%
Therefore, IRR can be calculated as follows:
IRR = 40% + 41% = 40.5%

2
Page 68 of 72
CHAPTER 7: RISK AND RETURN
• What are investing decisions?
• What is the process involved in investment decisions?
• What are the factors taken into account when making investment decisions?
• Investment decisions
2. WHAT ARE INVESTING DECISIONS?
• Long term capital decisions

• Investing in resources to sustain business
• Aligned to strategic objectives
• Why are investment decisions important?
• Achieve business objectives efficiently & effectively & economically
• Maximise profit/returns & wealth to shareholders
3. WHAT IS THE PROCESS INVOLVED IN INVESTMENT DECISIONS?
a. Establish clear goals

• Driver of the decision (buying cloths for a function)
b. Identify all possible options

• Research of options (window shopping)
c. Evaluate the possible options

• Cost-benefit analysis (Capital budgeting techniques)
d. Prioritize possible options

• Risk-return analysis (Compare to expected value)
e. Investment decision
• Best possible option
f. Financing options
• Funding alternatives
4. WHAT ARE THE FACTORS TAKEN INTO ACCOUNT WHEN MAKING

INVESTMENT DECISIONS?
1. Cost of investment
2. Return of the investment
3. Risk (chances of not receiving the planned return)
Page 69 of 72
4. HOW IS THE EXPECTED RETURN ESTIMATED?
• It is based on estimated returns (similar investment & conditions)
• Is based on probability (changes that desired outcomes will be achieved)
• Is based on forecasting techniques
• Is based on assumptions made
• Is based on historical data – trend analysis
2015 2016 2017 2018 2019

Returns 12% 15% 18% 21% 24%
Required:
Calculate the expected return for 2019
Solution
There is constant annual increase of 3%
Assumption
Similar conditions will continue in future
Therefore, it can be forecasted that 2019 = 24% (21% + 3%)
2015 2016 2017 2018 2019

Return 12% 15% 11% 18% ?
Required:
Solution
Before you answer, ask yourself the following:
What was the cause for drop in 2017?
If 2017 was abnormal year = therefore exclude this year from the analysis
Therefore, 2019 = 21% (18% + 3%)
Exercise 1
2015 2016 2017 2018 2019
Return 12% 20% 16% 18% ?
Required:
Page 70 of 72
5. OTHER FORECASTING TECHNIQUES
• Time series analysis
• Regression analysis
• Probabilities (Changes that desired outcomes will be achieved)
• Estimated returns
Prob Return
Condition 1 30% 22%
Condition 2 45% 26%
Condition 3 15% 28%
Condition 4 10% 30%
100%
Required:
Calculate the expected return
Solution
Prob Return Expected return
Condition 1 30% x 22% 6.6%
Condition 2 45% x 26% 11.7%
Condition 3 15% x 28% 4.2%
Condition 4 10% x 30% 3.0%
Expected return (Weighted average) 25.5%
6. INVESTMENT DECISIONS
• Balance returns with risks

• Maximise return & minimise risk
• Minimise the fluctuations of the expected return
• Coefficient of variance = Compare risk (Standard deviation) to expected return
o To do this you look at your Range & width of the returns
o Coefficient of variance
Investment A B C
Maximum return 45% 16% 27%
Minimum return 28% 17% 22%
Fluctuation/risk 34% 2% 11%
The financial manager stated that the investment decisions must be based only on the
expected return.
Required:
a. Comment of the statement made by the financial manager
b. Indicate which investment has the lowest risk
c. Calculate coefficient for each of the investments
Page 71 of 72
Solution
a.
Basis of making investment decision
-Prioritise based on risks and return
Prioritisation
-Maximise returns & minimise risks (coefficient)
-Risks affects the actual return that will be received
-Level of fluctuation vs risk appetite
Basis of making investment decision
: Investment cost
: Return
: Risk
Therefore, F/M is incorrect
Therefore, the financial manager is incorrect
b.
A B C
Risk High Low Moderate
B has less fluctuation/risk
c.
Is an art of comparing return with risk simultaneously / all together
How is it calculated?
Coefficient variance = Risk/ Expected return
A B C
Return 28% 17% 22%
Coefficient 34%/28% 2%/17% 11%/22%
121% 11.76% 51%
Decision:
Select best investment
Return 1 3 2
Risk 3 1 2
Co-efficient 3 1 2
Best
Page 72 of 72
Exercise 1
Nozi Ltd has the following data
Investment options A B C D
Expected return (which is also average) 25% 17% 13% 20%
Risk (variance/fluctuations) 8.4% 4.9% 1.6% 5.9%
Minimum return (expected return – fluctuation) 16.6% 12.6% 11.4% 14.1%
Required:
a. Calculate the maximum return for all the investments
b. Calculate coefficient for each of the investments
c. Prepare an investment prioritization schedule that will assist Nozi Ltd management to
make informed decisions.
Page 73 of 72

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FACULTY OF ACCOUNTING & INFORMATICS

DEPARTMENT OF MANAGEMENT ACCOUNTING

PROGRAMME TITLE: Diploma in Management Sciences

PROGRAMME CODE: DIMBS1

SUBJECT TITLE: FINANCIAL MANAGEMENT III

SUBJECT CODES: FNMG301

SAQA CREDITS: 12 credits

STUDY GUIDE 2024

Revised by: Mr Thabiso Sthembiso Msomi

Names of Lecturer : MR THABISO STHEMBISO MSOMI

Departmental Secretary : Bongekile Giqwa

Departmental HEAD : Dr Zwelihle Wiseman Nzuza

Room number : DC1204F

Lectures : 4 periods per week

The following important rules apply to the aegrotat test: -

ASSESSMENT DATES: (provisional dates)

Faculty MANAGEMENT SCIENCES Department

1 Module title FINANCIAL MANAGEMENT 3 2

5 HEQSF level 6 6 HEQSF Credits 16

Tracking changes to the module descriptor [to be completed by CQPA]

CHAPTER 1: Corporate Governance, Ethics and

1. What is corporate governance?

2. Sources of Corporate Governance

There are three 3 sources for Corporate Governance:

3. Approaches to Corporate Governance

There are 4 approaches in the practice of corporate governance:

a. The Shareholder Value Approach

b. Stakeholder Approach (practiced in Zimbabwe)

c. The Integrated Approach

4. Rolls in the company

The role of the entity’s CEO

The company Secretary and Corporate Governance

A company secretary bears the following tasks and responsibilities, namely:

• Attends those meetings and takes minutes.

• Notifies shareholders of changes in their shareholding – not only shareholders but

• Arranges insurance cover for board members.

The Company Lawyer and Corporate Governance

The in-house company lawyer is an alternative to the company secretary as a source of

• The right to remove a director from office – a group of shareholders proposing to

The Role of the entity’s Stakeholders

• Appointing the first directors to conduct the affairs of the company

• Attend stakeholder meetings.

Other Stakeholders – employees, customers, lenders & other creditors, investment

• Customers want companies that produce good products to continue to do so.

The General Public – corporate social responsibility

What is the role of agency theory in corporate governance?

Agency loss drops when the following situations occur:

1.1 Define what is ‘corporate governance’

Reasons for holding cash

The need for a safety supply of cash to act as a financial reserve.

The need to have cash on hand to pay accounts.

FLOAT, CASH COLLECTION AND CONCENTRATION

Costs of Holding Cash

Components of Credit Policy

Collection policy - Procedures followed by a firm in collecting accounts receivable.

• Length of the credit period varies from industry to industry.

• Other factors influencing credit period: